Portfolio Rebalancing

What is Portfolio Rebalancing?

The process of adjusting the asset weightings in a portfolio back to its original target allocation is referred as portfolio rebalancing. It aims to ensure that the portfolio remains in line with the objectives and risk tolerance of its investors and involves reducing the weight of the positions that have appreciated significantly, and therefore have increased their weight in the portfolio, and topping up those that have underperformed. While a portfolio should be rebalanced periodically, the frequency depends on the investment strategy in addition to the prevailing market conditions.

How Portfolio Rebalancing Works?

The portfolio rebalancing process involves several key stages.

1. Setting Target Allocation – The investor determines the desired asset allocation in the portfolio based on investment goals, risk profile and time horizon. Such allocation would typically include a combination of equities, fixed income, alternative assets (including real estate) and cash
2. Determine a Strategy – Select a rebalancing strategy based on predetermined rules. This could involve rebalancing at a specific time intervals (for example quarterly or annually), or when deviations breach a certain threshold (for example 5% deviation from the target allocation). Specific market conditions can also be used as a rule to build a rebalancing strategy
3. Portfolio Monitoring – this step involves regularly reviewing the performance of the portfolio, its current allocation of assets and how has that evolved over the period of the review
4. Identify Deviations – Compare the current portfolio positioning against the target allocation and identify any deviations. These can be driven by changes in market values and/or the performance of specific asset classes
5. Execution – this stage relates to processing the trades necessary to bring the portfolio back to its desired asset allocation. It may involve selling outperforming assets and using the proceeds to buy more of those that have underperformed

The below chart illustrates the process of portfolio rebalancing.

Types of Portfolio Rebalancing

There are several approaches to portfolio rebalancing that incorporate the preferred frequency and thresholds. Below are some of the most popular approaches:

• Calendar-Based Rebalancing (also referred as Time-Based)

This approach involves rebalancing the portfolio periodically. For example, the frequency can be monthly, quarterly, or annually and is not related to any specific market conditions. As a general rule, the more frequent rebalancing would keep the portfolio closer to its objectives and target benchmark, but would also trigger higher transaction costs

• Threshold-Based Rebalancing

This approach requires setting specific thresholds within which the portfolio allocations are allowed to deviate. Rebalancing is triggered only when a threshold is breached. This method requires a more regular portfolio monitoring and smaller thresholds, would maintain the portfolio closer to its objectives, but would also lead to higher transaction costs

• Calendar and Threshold Rebalancing

As the name suggests, this method is a combination of the two abovementioned and requires monitoring of the asset weightings at pre-determined periods but trading (i.e. making changes to the portfolio weightings) only if a rebalancing threshold has been exceeded

There are many rules that can help design a portfolio rebalancing strategy. In addition to the more established approaches above, other examples include rebalancing a portfolio only when making new purchases or sales, or in response to significant market events (often referred as “opportunistic” rebalancing).

Advantages and Disadvantages of Rebalancing

As the key objective of portfolio rebalancing is to protect investors from being overly exposed to unintended risk, proper strategy and execution and indeed reduce the volatility in a portfolio. According to a Morningstar study, “no rebalancing at all results in far higher levels of portfolio volatility, while all of the other rebalancing frequencies led to similar reductions in portfolio volatility over a 15-year period”. In addition, although rebalancing is not intended to boost returns, a portfolio that is regularly rebalanced is likely to produce a better risk-adjusted performance over the long-term.

On the other hand, investors should carefully explore the right for them strategy and frequency of rebalancing as costs such as brokerage fees and taxes (for example capital gains tax), may erode returns (especially in frequent rebalancing). Moreover, selling appreciating assets during a market rally could create a missed opportunity capitalise on further gains.

To help you understand volatility better, in this video we explore how is it measured.

Does Rebalancing Have Costs?

As portfolio rebalancing requires buying and selling assets, the process also leads to additional costs and charges that investors should consider. In some cases, depending on the rebalancing strategy, transaction costs could outweigh the benefits of rebalancing. This is most likely to happen where small deviations from the original target allocation (for example less than 1%) trigger a trade. In addition, transaction costs tend to rise during periods of elevated market volatility, which makes rebalancing expensive. There is also a danger that a period of market turbulence may initially require rebalancing in one direction and then a reverse transaction, since the market may have turned the opposite direction.

What is Automatic Portfolio Rebalancing

Automatic portfolio rebalancing is a systematic method that requires the use of a specialist software to automate the necessary adjustments to the current asset allocation of a portfolio to bring the portfolio back to its original target allocation. From a technical perspective the process is the same – it involves buying and selling assets and can be based on various triggers, such as calendar/time intervals, specific thresholds, or market moves.

Why is Portfolio Rebalancing Important?

Rebalancing is an important part of the investment process as it helps investors maintain discipline in their investment strategy and eliminate emotions during periods of market turbulence. Research from Vanguard found that a portfolio with 60% invested in equities and 40% in fixed income at the end of 1989, if never rebalanced, would have had 80% in equities at the end of 2021. This further demonstrates the striking difference rebalancing makes in protecting investors from additional risk.

Source: Vanguard

Along with maintaining investment objectives, rebalancing also optimize performance. A study from T. Rowe Price found that “rebalancing with a 3% threshold led to a balance increase of over $10,000 and a 56-basis-point increase in annualized returns over a 10-year period compared with a portfolio without rebalancing”.

Source: T. Rowe Price

Conclusion

To sum up, rebalancing is a vital component of the portfolio management process that aims to control risk and keep the portfolio in-line with its objectives. There are a couple of popular strategies that investors can pick from that are based on either the frequency of rebalancing or pre-determined thresholds. Different studies show that rebalancing also leads to better returns over the long term, but nevertheless, investors should be mindful of the strategy they select as too frequent rebalancing may erode returns due to incurring higher transaction costs.

Additional Resources